Inflation Puts Commercial RE Investors On Edge
The 10-year U.S. Treasury’s volatile yield lately strikes fear in some commercial investors. 2023 was “a dismal year” after the cost of capital affected valuations.
NEW YORK – Trying to predict how Jerome Powell and the Fed will fight inflation has the Treasury market singing Van Halen’s 1984 hit “Jump” as unprecedented volatility in the benchmark 10-year Treasury yield over the past few months has commercial real estate investors on edge.
Since commercial real estate is a capital-intensive investment where most purchases are highly leveraged, the cost of capital plays an important role in valuations. Valuations are depressed when compared to several years ago, but the Fed’s steady drumbeat of Federal Funds rate increases reached an inflection point over the past month, helping ease the pain. The market is now hoping to come back from dismal transaction volume in 2023.
According to its most recent earnings release, Walker & Dunlop’s third-quarter transaction volume was off some 49% when compared to the same period in 2022. Likewise, CBRE published a report in October indicating that third-quarter 2023 commercial real estate transaction volume was down 54% compared to 2022.
Generally, a decline in transaction volume can be attributed to a lack of liquidity, meaning lenders aren’t lending. Volume also tends to drop when there is no conviction in the market.
Today, we are a victim of both. There is a liquidity crunch because so many lenders have legacy loans that are potentially problematic. That makes them more particular about who they will lend to and on what type of asset. The other obvious pinch on liquidity is that the high cost of capital is creating the need for more equity in every deal.
The need for more equity in a transaction and the lack of clarity about the economy and rates over the long term have guided most institutional money to the sidelines. They have no conviction about valuations and don’t want to catch the proverbial “falling knife.”
To be clear, those that are sitting on fixed long-term rates that were locked in a few years ago are not feeling much pain and don’t want to sell into a directionally challenged market. It is current owners that have a loan maturity coming up that have to make a decision about selling or refinancing and perhaps putting more equity into a project. This dilemma is playing out most prominently in the collateralized loan obligation (CLO) market.
CLOs are public lending vehicles that many non-bank banks or so-called “shadow banks” use to gain cheaper leverage on pools of loans they originate. Since most CLO loans carry floating rates, the dramatic increase in short-term rates over the past two to three years has put tremendous pressure on borrowers whose loans are maturing.
A large multifamily investor out of Austin, Texas, by the name of GVA Real Estate Group is struggling to keep up with rising rates on several of its over $2 billion in multifamily loans and has defaulted on several, according to Commercial Mortgage Alert. This is likely to be a trend that continues.
As rates have risen, the good news is that investors with cash and no legacy issues can take advantage of lower pricing available on projects that clear the market. Cap rates, which are a barometer for valuation and move in opposite direction as value, have risen significantly as rates have raced higher.
According to the John B. Levy Commercial Mortgage Survey, 5- and 10-year loans price as low as 6.25% to 6.50% for lower leverage deals, but mid- to high 7% range for most borrowers. Floating rate loans are pricing in the 8% range with SOFR at 5.30% and spreads in the 250-300 over range.
As an example of how difficult the market is, Tysons Corner Mall, which has regularly been noted as one of the best malls in the country, is currently going through a refinance where the LTV is reportedly 39%. The 5-year fixed rate loan is expected to price around 6.85%, according to Commercial Mortgage Alert, a significant jump from the current rate of 4.13% on the $666 million loan.
Market conditions locally are reflective of what is going on across the country. There is a lack of significant transaction volume in most asset classes with the notable exception being industrial properties. Overall occupancy remains strong for all property types.
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